Federal endorsement and interaction with regional officials in the process of Greenfield and Brownfield investment projects implementation

Moscow, November 2013

Presentation for the members of Association of European Businesses

Contents

What drives localization in Russia?

How localization is done by different companies?

What are potential or existing benefits companies?

How to make the most from the federal and local

endorsement?

Optimal solutions

What drives localization in Russia? There are no formal regulations formulating rules of game for localization in

Russia. The state rhetoric: ‘you can localize but we can give you no guarantees

it will help you keep and raise share in state purchases or any other

guarantees’.

One of the key criteria for implementing a foreign

direct investment (FDI) project or localization of

production is the willingness to keep and raise

share in state purchases.

Localization is considered as a gate jumper for a

company to avoid both tariff (customs duties)

and non-tariff regulations (localization helps

decreasing the warranty period of the locally

produced goods) in a legal field.

Business

Business

As a secondary reason logistics issue, shortening the shipment distance and

proximity to clients are often mentioned.

Example:

Market leader in energy management located their Technology Service Centre in Kaluga region (2010) so that to be able to provide service on turbine maintenance for its local clients.

Finally, it often happens that the key goals of localization set in the beginning

of the project couldn’t be achieved due to different reasons.

Example:

Global insulin producer has a strong Russian competitor Pharmstandard that is said to be affiliated with Russian authorities ensuring it allegedly has informal preferences in tender process. Thus keeping the company’s share is an issue much more complicated that couldn’t be 100% solved by localizing.

The majority of tomograph‘s components components are not produced in Russia and have to be imported after high customs duties are paid (customs duties for a tomograph are lower than for its components). Thus global tomograph producer couldn’t decrease prices.

The benefits for the state are obvious: they are increasing local

investments, creating local jobs, increasing locally paid taxes.

Potentially decreasing prices of the end product for the population.

It also gives the state officials the leverage to make companies more

flexible (dependent as they are localized now) and force them to pay

before, during and after the FDI project is implemented.

Automotive sector is the most successful example of

localization. The state has been implementing industrial assembly

program for more than 7 years already. The government has

provided very favorable conditions for car manufacturers motivating

them to localize production. This example was accompanied by the

strong political will of Putin himself. He really wanted to attract

investors hence everything was prepared in a proper way.

The state

How localization is done by different companies?

Localization by different companies Majority of companies in all sectors tend to start with a minor project, test-drive the

region, the production and sales opportunities and then to proceed to further

investments and deeper localization.

Foreign car manufacturers, for example, have been localizing production gradually,

and now they have to achieve 80% of localized production during an average period of

5 years starting 2012 (some were given 7 years). After this period of time regular

import tariffs will be re-introduced for them.

Some investors only announce the full cycle localization in X number of year. Some

declare their commitment to Russia but don’t want to invest a lot today and leave a

decision until tomorrow as situation may change and they won’t invest at all.

There are such economy sectors like pharmaceuticals, that are mostly dependent on

the state purchases thus they decide to proceed quicker than their colleagues in other

sectors. In other words localization format including its depth and type depends on an

industry sector.

Production localization vs. soft projects (R&D, etc) After evaluation of expected benefits of localization in financial

terms companies decide to pursue either production localization or soft

projects. Or both.

Production

Coca-Cola opened its first plant in Russia as early as 1994.

Ford could be considered as one of the pioneers in the localization process as well (2002). They also took part in preparation of localization Decree signed by Ministry of Economic Development, Ministry of Industry and Ministry of Finance (2005). It defined the criteria for industrial assembly for the whole automotive industry. The pioneers were provided with the most favorable conditions, sending an important message to other investors.

On the over hand the following negative aspect could be underlined:

High construction costs and administrative barriers and

difficulties when starting operations in Russia lead to long term and low

Net present value/Internal rate of return for projects in most sectors.

Research & Development projects (R&D) Could R&D and training projects be considered as an option? FDI is

largely taken for granted. While R&D and training projects can

add real value. Sometimes even reduce expectations for local

manufacturing.

Examples:

IBM decided to open Russian Systems and Technology Laboratory (2006) in Moscow which became part of the IBM research centers network worldwide. IBM has only R&D facilities in Russia

Honeywell (major American producer of commercial and consumer products, engineering services and aerospace systems) opened a center of technological solutions in St. Petersburg (2010), designed to develop innovative capital and organize a research center. Then opened a Centre for Technology Studies in Skolkovo (2012) that will develop innovative solutions for the processing industry.

Major French producer of electrical systems for aerospace could be

mentioned as a negative example as it lost market share and huge

contracts with state when declined opening of R&D facility in Moscow.

Production and soft projects Pfizer implements 2 localization projects:

Joint project of Pfizer and NGO Petrovax Farm to localize the production of pneumococcal vaccine (2011)

Pfizer signed a memorandum of understanding with Biocad to explore the possibility of localization of innovative drugs production for the treatment of hemophilia (2012)

On the other hand Pfizer launched a soft project as well:

Together with the Moscow Institute of Physics and Technology it signed an agreement on cooperation in the sphere of development and implementation of joint educational program for talented students and young scientists (2011). Ministry of Economic Development oversees this program.

Localizing both production and soft projects in Russia doesn’t

guarantee you market access or give you a competitive advantage on

the market. But companies like Pfizer try to pull all kind of strings to

maintain market access.

In the Special Economic Zones (SEZ) vs. in other regions

Localizing in SEZ gives you the opportunity not to pay customs duties for

equipment imported as a contribution to share capital. Immediate investments

costs in SEZ are comparatively lower than in other regions. But future operating

costs are much higher than in other regions. There are also certain time

management risks connected to implementing projects in SEZ, such as time

consuming approval procedures and delaying decisions by the management of

SEZ in terms of the construction process.

The latest example is a market leader in ceiling production in Alabuga SEZ.

While in other regions you may agree on different conditions from tax holidays

to summing up of infrastructure. Such type of projects bare, mainly, market risks.

The most important thing is that such projects provide an opportunity for an

individual approach, i.e. to negotiate exclusive conditions. Usually it depends on

your GR department or consultants, the quality of due diligence they

implemented and their negotiations skills.

Market leader in energy management secured nearly perfect conditions for locating a production unit that will specialize in the manufacture, sale and service of gas turbines in Yaroslavsky region (2011).

With partner (joint ventures) vs. without partner Important to decide whether the partner adds value to your project. It

often happens in Russia especially in the pharma and medical devices industries

that you have to partner with some Russian company to be included into the list

of strategic companies or into the state purchases. An investor may also decide

to partner with a Russian company to shuffle off the burden of corruption risks

on a Russian partner.

On the other hand foreign investors often look for local state-owned partners

without any clear understanding of possible difficulties that may follow. As such

state companies may only capitalize on the promotion of partnership and don’t

really invest their time and money to support FDI project.

With partner

OTIS elevators production in Russia in 1992 as a joint venture with Moslift. Novartis and JSC RT-Biotechprom signed an cooperation in drugs localization

for the treatment of chronic myeloid leukemia (2012). Without partner Siemens bought a bulb factory in Smolensk (2003). Market leader in energy management located their Technology Service Centre

in Kaluga (2010).

Greenfield vs. Brownfield Brownfield could be cheaper in terms of the costs as the facilities

already exist thus ensuring the length of the FDI project is shorter as

well. Moreover it could be a good starting point before you launch a

Greenfield project.

Global cement producer bought 2 plants in Moscow and Chelyabinsk regions (1995). Now considers launching a Greenfield project at least in Kaluga region while Rostov region may follow.

In pharma or other high-end sectors it is preferable to go for

Greenfield as old infrastructure could limit the opportunities to launch

a really up to date production facility.

Nycomed following other healthcare competitors that have already done so decided to launch a Greenfield project in Yaroslavl region (2010).

Greenfield vs. Brownfield However, it is important to understand that costs of reconstruction in

Russia are higher than costs of a new construction site if we compare

the costs per 1 square meter correspondingly.

If you plan to develop within the limits of existing Brownfield site, it could be

considered as an option.

But if you have development plans implying expansion, then Greenfield is

preferable as it is more profitable to gradually expand your production based

on well-thought strategic plan and not to be limited to a small land plot.

Moreover if you have time constraints and tight deadlines, approval of re-

construction with authorities is much more complicated compared to

Greenfield and requires significant time thus it may lead to delays in project

implementation.

What are potential or existing benefits for the companies in terms of the state purchases and business development? How to make the most from the federal and local endorsement?

Potential benefits

Localization is only one of the tools to increase your market share. It’s not

a magic wand.

Sanofi use both production localization (Bioton Vostok Brownfield insulin production in Orel region (2010) and realize partnership projects like co-production of polio vaccine with Institute of Poliomyelitis and Viral Encephalitis named after M.P. Chumakov within Russian academy of medical sciences (2008) to keep and increase their market presence. This co-production became feasible only after they reached a partnership agreement with Sergey Chemezov, Head of Russian Technologies.

Among other issues it is important to consider whether you have Russian

competitors in specific business segments and how strong is the existing

local production. Even under the new WTO conditions (Russia has finally

accessed WTO on August, 22, 2012) it will be protected.

Consider what other foreign competitors have already done on the

market.

It is essential to use leverage of the governors as they are ‘A’

class officials meaning they are equal to any federal minister and

can outreach them easily if it can attract investors into their

region.

You can even transfer payment of taxes to a region where a

governor is supportive as he may help you secure federal

endorsement for your FDI plans.

Not entirely a crazy idea if you consider what a powerful political

leverage a governor may be to you provided you have invested

or plan to invest in his region. You definitely need to consider

this instrument and use it wisely to achieve your goals.

Potential benefits

Optimal solutions

Optimal solutions Political decision on localization should only be made when you are squeezed out of

the market by a Russian competitor or a company affiliated with state authorities.

And you don’t have any other opportunity to stay on the market.

In all other situations well-thought economic analysis is key when taking

decision on localization. Some preliminary questions to focus on and to start with

the search for the optimal solutions:

Could you evaluate expected benefits of the localization in financial terms (increasing volume of sales and money)?

What is the size of the market for your product and consumption? What are the import amounts?

What is the consumption growth trend? What is the regulatory trend? How do they influence one another?

Do you have Russian competitors on your market? If yes, then how active and influential are they?

Is your market dependent on state purchases? How heavily? Have you received any guarantees on investment conditions/state purchases

benefits from the officials both federal and regional? Are they formalized in a written form?

Contact

Pavel Melnikov

Vice President,

Public Affairs & Crisis Communications

Mobile: +7 (963) 962 19 29

E-mail: pavel.melnikov@grayling.com, pol.melnikov@gmail.com

Grayling Eurasia+7 (495) 788 67 84

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Moscow 127473

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